Romania: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
26 Jul 2004
eISBN:
9781451832792
Language:
English
Keywords:
ISCR; CR; interest rate; rate; inflation movement; disinflation strategy; labor cost shock; inflation inertia; inflation variability; Consumer prices; Disinflation
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This Selected Issues paper for Romania reports that the practice of nonpayment and arrears accumulation has been widespread in Romania. Managers of enterprises that remain in the pipeline for privatization for long periods of time have little incentive to reduce arrears. The state contributed to growth of arrears by accepting nonmonetary tax and utility payments, using tax offsets in procurement, and tolerating payment arrears. These practices have been prevalent at all levels of state and local government, as well as state utility companies.

Abstract

This Selected Issues paper for Romania reports that the practice of nonpayment and arrears accumulation has been widespread in Romania. Managers of enterprises that remain in the pipeline for privatization for long periods of time have little incentive to reduce arrears. The state contributed to growth of arrears by accepting nonmonetary tax and utility payments, using tax offsets in procurement, and tolerating payment arrears. These practices have been prevalent at all levels of state and local government, as well as state utility companies.

II. Sources of Inflation and Disinflation Policies in Romania17

A. Introduction

1. Since 2001, the Romanian economy has enjoyed a virtuous combination of high growth and gradually improving internal and external stability, exemplified by falling inflation, rising international reserves and generally manageable current account deficit. Nevertheless, inflation has fallen relatively slowly, and as of April 2004, Romania still has one of the highest inflation rates in Europe at 12½ percent. This note aims to analyze the factors that have kept and are still keeping inflation in double digits and recommend disinflation policies to bring it to mid-single digits without harming external stability or growth.

2. Sources of inflation can be classified in several categories:18

  • Financial market disequilibria, possibly caused by a weak fiscal position, which surface as exchange rate or money shocks.

  • Demand-pull factors: shocks in aggregate demand, measured by changes in the output gap or other real activity variables.

  • Cost-push shocks: hikes in international prices of intermediate inputs (oil, metals, etc.), domestic administered price increases, as well as labor cost pressures.

  • Inflation inertia: a sluggish response of prices to disinflation policies. This sluggish response may be due to low policy credibility, staggered price and wage contracts, a backward-looking component in the formation of inflation expectations, or the costs of frequent reoptimization of the price setters’ objective function.

  • Inflation persistence: slow dissipation of second-round effects after shocks. Note that persistence is different from inertia.19 Inertia is usually defined as the speed of reaction of inflation to unanticipated shocks, including policy ones, while persistence is measured as the time needed for the effect of these shocks, once passed through to inflation, to die out.

3. We analyze the relative importance of these channels in Romania, as well as the sensitivity of inflation to various shocks, by a recursive vector autoregression (VAR) framework, in the period from late 2000, when the current strategy of gradual disinflation was adopted, to early 2004. We present the econometric methodology and the list of variables in Appendix I.

4. We find that inflation persistence is the most important source of inflation, followed by exchange rate and labor cost shocks. Shocks from administered prices propagate only moderately and dissipate fast, while demand shocks are insignificant. Monetary policy works mostly through the exchange rate, while the direct impact of the policy interest rate on inflation is modest. As continuing reliance on the exchange rate for disinflation seems unavoidable, it is imperative that monetary policy be relieved from current account considerations by wage restraint and a tight fiscal stance.

5. The plan of this paper is as follows. After a brief reckoning of inflation developments, we describe in Section C the policy framework underlying the disinflation effort. Then, in Section D, we discuss the relative importance of inflation factors in Romania before turning to analyzing inflation’s reaction to shocks in Section E. Section F concludes and draws some policy implications.

B. Inflation Dynamics in 2001–04

6. In the past three years, the 12-month consumer price inflation rate in Romania has been falling in almost monotonic fashion. It dropped from 40 percent in January 2001 to 12½ percent in April 2004, while producer price inflation fell from 50 percent to 18 percent in the same period (Figure 1). Food prices, with a weight of over 40 percent in the consumer price index (CPI), led the decline, while services initially lagged (Figure 2). More important, inflation declined against a background of sizable adjustments in gas and electricity prices,20 aimed at bringing the former closer to import parity and the latter to cost recovery levels. As these adjustments affected producer prices more heavily (especially in 2002 and late 2003), producer price inflation declined more gradually.

Figure 1.
Figure 1.

Consumer and Producer Prices, 2001-04

(Percent change over 12 months earlier)

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Sources: Romanian authorities; and Fund staff estimates.
Figure 2.
Figure 2.

CPI Components, 2001-04

(Percent change over 12 months earlier)

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Sources: Romanian authorities; and Fund staff estimates.

C. Romania’s Disinflation Strategy

7. Romania’s disinflation is gradual by design. Formulated in early 2001, the disinflation strategy acknowledged the obstacles to fast disinflation imposed by Romania’s circumstances. With the large pass-through from the exchange rate to prices, any monetary policy framework aiming at disinflation had to rely on the exchange rate as a nominal anchor. However, in the presence of rigid collective labor contracts and wage setting with a backward-looking component, rapid disinflation could easily result in an unsustainable real exchange rate appreciation and a sizable current account imbalance. The authorities therefore opted for the less ambitious (and less risky) target of cutting inflation by roughly one-third every year, and two policy pillars, the exchange rate and wage restraint. In the event, the strategy worked well, with the established inflation targets for 2001–03 either met or improved upon.21

8. Relying on the exchange rate as a soft nominal anchor and high interest rates, monetary policy has reduced inflation and accumulated reserves. Over the last three years, the National Bank of Romania (NBR) has guided the exchange rate broadly in line with the disinflation target and the scope for real effective appreciation resulting from the productivity growth differential. The restrictions on nonresident purchases of T-bills and deposits with local banks have afforded the NBR a degree of autonomy in setting its policy interest rate, which it has used mainly to support the desired exchange rate dynamics and reserve accumulation. This framework has successfully anchored inflation expectations by avoiding large and disruptive fluctuations in the exchange rate.

9. The authorities’ record on wage policies—the second pillar of the disinflation strategy—has been mixed. Wage policies have two facets: minimum wage setting and wage control in state-owned enterprises (SOEs), where financial discipline has much room for improvement. Both aspects are intertwined, as SOE wages are generally linked to the economywide minimum wage through a system of markups for rank and experience, which are set in a multilayered system of collective contracts. After a difficult start in 2001, wage policies improved significantly in 2002, contributing to the inflation overperformance in that year. However, 2003 saw a sharp minimum wage increase (of 43 percent), which sparked strong economywide wage growth and necessitated a slowdown in the speed of disinflation. Once again, policies tightened in 2004 (targeting a zero real increase in the minimum wage and SOE wages on an annual average basis), helping to sustain the disinflation trend. Overall, the combination of wage policies and large social security cuts led to declining real unit labor costs (see Figure 3), thus minimizing supply shocks on inflation.

Figure 3.
Figure 3.

Unit Labor Cost Deflated by Domestic Producer Prices

(12-month moving average; 2000=100)

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Sources: Romanian authorities; and Fund staff estimates.

D. Relative Importance of the Various Sources of Inflation

10. The variance decomposition of the forecast error, which is based on the estimated variance-covariance matrix of the model, gives the contribution of each of the variables included in the VAR to explaining inflation variability. While a small contribution indicates that the variance of the respective VAR variable explains less of the variance of inflation than competing variables, shocks associated with such a variable can still have a sizable impact on the level of inflation (see Section E). The results are presented in Tables 1a and 1b for consumer and producer price inflation, respectively.

Table 1a.

Variance Decomposition of Consumer Price Inflation

(Percentage points)

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Table 1b.

Variance Decomposition of Producer Price Inflation

(Percentage points)

article image
Legend: ADM - administered prices; TLC - labor costs; GAP - output gap; RBAS - exchange rate; CPIC - consumer price inflation; IR - policy interest rate; PPI - producer price inflation.

11. Persistence is the most important source of inflation. Past realizations of the own inflation shock account for almost 60 percent of its variance at the policy-relevant horizons of 12–24 months. As formal indexation schemes (which could explain this finding by allowing past inflation to influence current wage and price setting) were not practiced over the analyzed period, this result probably reveals the expectations of price setters for gradual and smooth disinflation. To some extent, these expectations may have been influenced by the success of the chosen gradual disinflation strategy, as persistence seems to have increased over time.22

12. Cost-push factors—administered prices and labor costs—are responsible for about one-sixth of all inflation movements. The small contribution of labor cost (relative to other factors), which is robust to various VAR orderings and wage measures, comes as a minor surprise. One explanation is that wage growth has been offset by social security cuts and rising productivity, so that the unit labor cost actually declined in real terms and did not pressure prices (see Figure 3).

13. Exchange rate volatility accounts for about one-seventh of the variation in inflation. This relatively small contribution merely reflects the low variability of the exchange rate compared with inflation, which is not surprising given the exchange rate’s role as a nominal anchor. In terms of channels of influence, the exchange rate affects inflation both as a cost-push factor and as a guide to inflation expectations. Both roles require relatively low variability, especially in view of the exchange rate’s large pass-through (see Section E).

14. Demand-pull effects, proxied by the output gap in industry, play a minor role. The weight of demand-pull factors remains small even if we replace the labor cost variable by the net wage and treat it as an additional proxy for demand shocks. This result, shared with other economies in the region,23 probably reflects the authorities’ success in steering the nominal anchor (the exchange rate) on the desired path, so that demand shocks affect primarily the current account deficit, rather than inflation.

15. The small contribution of the interest rate is not surprising, given the low level of monetization and credit relative to GDP, as well as the gradual and smooth disinflation path (see Figure 1). With shallow financial markets and restricted capital mobility, interest rate changes would have only moderate effect on domestic demand and financial flows, translating into a moderate impact on prices. Also, as the inflation target was largely met in 2001 and 2003 and substantially overperformed upon in 2002, there was little particular need to use the interest rate to battle shocks to inflation (aside from the second half of 2003). This small weight is a restatement of the fact that most of the impact that the exchange rate has on inflation in Romania comes not directly, but via its effect on the exchange rate, as confirmed by the impulse response analysis in Section E.

16. Policies have a heavy impact on producer price movements. In marked contrast to consumer prices, own shocks explain only about one-fourth of the fluctuations in producer price inflation. Variations in policy-influenced variables—the exchange rate, labor costs and administered prices—are responsible for about two-thirds of producer price movements. This is in fact a positive result, as it shows that policies can have an even stronger impact on changes in producer prices, which bodes well for bringing producer price inflation down to single digits in 2005. The slower decline in producer price inflation, compared with the CPI inflation, can be attributed to the much larger influence of the hikes in administered prices (mostly energy, but also water supply, railway transportation, and telecommunications).

E. Sensitivity of Inflation to Shocks

17. While the variance decomposition described above gives the relative importance of each variable included in the VAR in explaining inflation movements, the pass-through coefficients, computed from impulse responses, measure what fraction of each particular shock is eventually transmitted to inflation. To the extent that these shocks are policy induced, this analysis shows the impact of various policies on inflation. The impulse response functions of consumer and producer prices, as well as those of the exchange rate to shocks emanating from the exogenous and policy variables in the model, are presented in Figures 4–6, while the corresponding passthrough coefficients are shown in Tables 2a and 2b.24

Figure 4:
Figure 4:

Response of Consumer Prices to Cholesky One S.D. Innovations ± 2 S.E.

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Figure 5:
Figure 5:

Response of Producer Prices to Cholesky One S.D. Innovations ± 2 S.E.

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Figure 6:
Figure 6:

Response of the Exchange Rate to Cholesky One S.D. Innovations ± 2 S.E.

Citation: IMF Staff Country Reports 2004, 220; 10.5089/9781451832792.002.A002

Table 2a.

Pass-Through to Consumer Price Inflation

(Percentage points)

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Table 2b.

Pass-Through to Producer Price Inflation

(Percentage points)

article image
Legend: ADM - administered prices; TLC - labor costs; GAP - output gap; RBAS - exchange rate; CPIC - consumer price inflation; IR - policy interest rate; PPI - producer price inflation.

18. Inflation in Romania exhibits low inertia. Romania’s consumer prices show little stickiness, as inflation’s response to shocks peaks between the first and the fourth month after impact (Figure 4). This is partly a function of the relatively high inflation during the period of analysis. Other studies on high- and moderate-inflation countries report similarly low inertia, while low-inflation countries in the region, like Croatia and Slovakia (although not Slovenia), show substantially higher inertia (see Table 3).

Table 3.

Response of Inflation to Shocks in Selected Countries

article image
Sources: Leigh and Rossi (2002) for Turkey; Belaisch (2003) for Brazil; Bhundia (2002) for South Africa; Billmeier and Bonato (2002) for Croatia; Kuijs (2002) for Slovakia; Ross (1998) for Slovenia.

19. Inflation persistence is average by international and regional standards. It takes about 15–20 months after the shocks for most of the impulse responses to return to zero. In other emerging markets, it takes 2–3 years for most shocks on inflation to dissipate25 and, in developed countries, at least 3 years26. However, regional comparisons show less persistence in Croatia and about the same in Slovenia. Persistence may be average relative to other countries, but it still dominates other sources of inflation in Romania, as shown in Section D.

20. The pass-through from the exchange rate is large and fast. Forty to fifty percent of exchange rate shocks are eventually transmitted to prices. Compared with previous estimates, the pass-through has indeed declined for producer prices but has increased somewhat for consumer prices.27 Possible explanations for the smaller PPI pass-through include (i) improved monetary policy credibility and exchange rate predictability at an annual horizon, resulting in price setters demanding a smaller premium for uncertainty; and (ii) better foreign exchange risk management, resulting in lower producer sensitivity to exchange rate changes. The increased pass-through to consumer prices is a puzzle, however, as it is expected to decline with lower inflation.28 Moreover, the same factors that affect the pass-through to producer prices should be in play for consumer prices as well. This remains an important issue for further research.

21. Labor cost shocks also have a large pass-through, commensurate to the exchange rate one. Interestingly, it is about the same for consumer and producer prices, indicating that wage dynamics affect consumer prices mostly as a supply shock, as presumed by the model, rather than as a demand shock.

22. The small pass-through of administered prices is a positive surprise. It indicates a high degree of competition, as the sizable increase in the administered prices, in particular for energy over the examined period, seems to have been successfully absorbed in the profit margins of economic agents, rather than passed to the consumer. Such resilience to this kind of supply shocks bodes well for further disinflation.

23. The direct effect of the policy interest rate on inflation is moderate. A 100-basis point increase in the policy interest rate would lower inflation by only 20 basis points after 12 months. However, as Figure 6 indicates, most of the effect of monetary policy on inflation comes through the exchange rate, whose reaction to interest rate shocks is both larger and faster than inflation’s. In addition to the direct effect, the same 100-basis points interest rate hike would result in a 65 basis points exchange rate appreciation after 12 months, and lower inflation by an additional ¼ percentage point.

F. Conclusion and Policy Implications

24. This analysis confirms that the gradual disinflation strategy chosen in 2001 has been and remains appropriate. The strong inflation persistence, coupled with the much-needed policy of raising administered prices toward cost-recovery/market levels, would have made faster disinflation rely too much on the exchange rate anchor and thus risk the loss of competitiveness. Albeit of secondary importance, administered price adjustments would continue in the medium term, as gas prices need to reach import parity and electricity prices should move in line with rising costs. Gradual disinflation, therefore, continues to be the safe and credible way to disinflate without creating external imbalances and sacrificing output growth.

25. Nevertheless, even gradual disinflation requires strong policies and smooth policy coordination. Although demand shocks have a minor effect on inflation, they have a major impact on the current account deficit, as the 2003 experience clearly showed. The policy package needed to deliver the inflation objectives of 9 percent for 2004 and 6 percent for 2005 without compromising external stability thus combines the continuing use of the exchange rate as a nominal anchor with tight fiscal and wage policies to reign in the current account deficit.

26. Guiding the exchange rate broadly in line with the inflation target and a modest real appreciation continues to be the policy with the highest disinflation potential. This policy anchors inflation expectations at an annual horizon while allowing sufficient short-term flexibility to prevent excessive speculation on the financial markets. Beyond 2004, however, the progressive relaxation of capital controls will generate strong appreciation pressure, especially if domestic interest rates stay high. While accepting more substantial real appreciation will certainly help in lowering inflation,29 it needs to be accompanied by a continuing increase in public and private savings to prevent further deterioration in the current account deficit.

27. Wage restraint is an important disinflation policy as well. First, the pass-through from wage shocks is quite strong, even though such shocks account for only a moderate fraction of inflation variability. Second, wage moderation is an “enabling” policy, allowing the NBR to use the exchange rate as a disinflation tool without fear of harming competitiveness. The wage policies in place in 2004 will help to both preserve competitiveness and moderate the current account deficit, thus allowing the NBR to focus on disinflation. Similar prudence will be required in the following years, to cope with the effects of the likely strong exchange rate appreciation pressures on the current account.

APPENDIX I Data Definitions and Sources

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APPENDIX II Methodological Notes

The methodology draws loosely on the reduced-form recursive model introduced by McCarthy (1999, 2000) for studying the impact of various exogenous and policy shocks on inflation. The vector autoregressive (VAR) framework allows for estimating the impact of each of these shocks on inflation from their impulse responses, as well as ascertaining the relative importance of each shock from its contribution to the variance decomposition of the forecast error. In this model we have included the following potential shocks on prices:

  • policy-driven administered price increases, measured by an index of administered prices, weighed with their CPI weights;

  • domestic price shocks, coming from increases in total labor costs. The inclusion of this variable is motivated by Romania’s history of wage-price spirals and the relevance of wage dynamics for inflation in the past (see, e.g., Moore (2001));

  • demand shocks, conventionally proxied by the output gap;

  • exchange rate shocks, which are an important inflation determinant in Romania;

  • monetary policy shocks, captured by the inclusion of the NBR’s policy interest rate. Ordered last, this equation is a reduced form of the central bank reaction function.

As large movements of administered prices are an important part of the overall CPI dynamics, we used a CPI measure that excluded administered prices. Moreover, as we have captured the most important supply shocks and to avoid double counting, we estimated the model separately for consumer and producer prices. The precise definitions of variables and the sources of data are provided in Appendix I.

The sample period consists of monthly observations between November 2000–March 2004. The choice of this sample is motivated by the need to avoid estimating the VAR model over different policy regimes, an approach subject to the Lucas critique (see, e.g., Favero (2001), pp. 162–208). As this period coincides with both the tenure of the current government and a stable monetary framework, we feel confident that the overall economic policy framework has stayed unchanged. All level variables (except the policy interest rate and the output gap) have been transformed in natural logarithms and seasonally adjusted with the X12 procedure.

Unit roots have indicated that the series in levels are nonstationary; thus, the variables are transformed in first differences to achieve stationarity.30 As recursiveness is generally supported by Granger causality tests, the Cholesky decomposition of the estimated variancecovariance matrix is appropriate for identifying the structural shocks. Experiments with different orderings of the variables did lead to similar results.

Lag length is chosen as the minimal number of lags sufficient to achieve “white noise” residuals, which resulted in one lag for the model including consumer prices and two lags for the model with the PPI.

The pass-through coefficients at horizon ‘j’, shown in Tables 2a and 2b are calculated as PTt,t+j = Pt,t+j/Xt,t+j, where P and X are the j-period-ahead cumulative impulse responses of the price measure and the shocked variable, respectively. This way of measurement, used in Rabanal and Schwartz (2001), Leigh and Rossi (2002) and Belaisch (2003), accounts for the total impact of exchange rate changes on prices for a given time horizon, including the secondary exchange rate dynamics generated by the initial shock. The series of direct noncumulative impulse responses of the consumer and producer prices as well as the exchange rate for 24 months after the shock are shown in Figures 4–6.

References

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  • Billmeier, A., and L. Bonato, 2002, “Exchange Rate Pass-Through and Monetary Policy In Croatia,” IMF Working Paper 02/109 (Washington: International Monetary Fund).

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  • Bhundia, A., 2002, “An Empirical Investigation of Exchange Rate Pass-Through in South Africa,” IMF Working Paper 02/165 (Washington: International Monetary Fund).

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  • Cespedes, L., M. Kumhof, and E. Parrado, 2003, “Pricing Policies and Inflation Inertia,” IMF Working Paper 03/87 (Washington: International Monetary Fund).

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  • Favero, C., 2001, Applied Macroeconometrics, New York: Oxford University Press.

  • Gueorguiev, N., 2003, “Exchange Rate Pass-Through in Romania,” IMF Working Paper 03/130 (Washington: International Monetary Fund).

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  • Kuijs, L., 2002, “Monetary Policy Transmission Mechanisms and Inflation in the Slovak Republic,” IMF Working Paper 02/80 (Washington: International Monetary Fund).

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  • McCarthy, J., 1999, “Pass-Through of Exchange Rates and Import Prices to Domestic Inflation in Some Industrialized Economies,” BIS Working Paper, No. 79, Basel, Switzerland: Bank for International Settlements.

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  • McCarthy, J., 2000, “Pass-Through of Exchange Rates and Import Prices to Domestic Inflation in Some Industrialized Countries,” Federal Reserve Bank of New York Staff Reports No. 111, New York: Federal Reserve Bank of New York.

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17

Prepared by Nikolay Gueorguiev.

20

With a weight of about 10 percent in the CPI in 2004.

21

2001: target 29 percent, outcome 30 percent; 2002: target 22 percent, outcome 18 percent; and 2003: target 14 percent, outcome 14 percent.

22

Compared with the analysis in Gueorguiev (2003) on data from June 1997 to January 2003.

24

See Appendix II for the definition of the pass-through coefficients.

27

Using data from June 1997 to January 2003, Gueorguiev (2003) estimates the exchange rate pass-through to producer and consumer prices after 12 months at 64 percent and 33 percent, respectively.

29

Some estimates of NBR economists put the Balassa-Samuelson effect at close to 5 percent per annum, suggesting that there is room for somewhat larger equilibrium real appreciation than the currently assumed 2 percent.

30

Strictly speaking, the VAR system should be represented as a vector error-correction model, including possible error-correction terms stemming from potential cointegration between some of the included variables in levels. However, cointegration tests indicate too many cointegration relationships between the six included variables, with low (and often borderline significant at best) adjustment coefficients. Ignoring the error-correction terms thus has no grave consequences in the relatively short time span of the analysis.

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Cover IMF Staff Country Reports
Romania: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 220
Publisher:
International Monetary Fund
ISBN:
9781451832792
ISSN:
1934-7685
Pages:
98
DOI:
https://doi.org/10.5089/9781451832792.002
  • View in gallery

    Consumer and Producer Prices, 2001-04

    (Percent change over 12 months earlier)

  • View in gallery

    CPI Components, 2001-04

    (Percent change over 12 months earlier)

  • View in gallery

    Unit Labor Cost Deflated by Domestic Producer Prices

    (12-month moving average; 2000=100)

  • View in gallery

    Response of Consumer Prices to Cholesky One S.D. Innovations ± 2 S.E.

  • View in gallery

    Response of Producer Prices to Cholesky One S.D. Innovations ± 2 S.E.

  • View in gallery

    Response of the Exchange Rate to Cholesky One S.D. Innovations ± 2 S.E.

Consumer and Producer Prices, 2001-04

(Percent change over 12 months earlier)

CPI Components, 2001-04

(Percent change over 12 months earlier)

Unit Labor Cost Deflated by Domestic Producer Prices

(12-month moving average; 2000=100)

Response of Consumer Prices to Cholesky One S.D. Innovations ± 2 S.E.

Response of Producer Prices to Cholesky One S.D. Innovations ± 2 S.E.

Response of the Exchange Rate to Cholesky One S.D. Innovations ± 2 S.E.